Just when you thought it was safe to go back in the water

On Tuesday Bearn Stearns (BSC) marched triumphantly back into the fixed interest market by putting away a $2.25 billion bond sale laying waste to rumors of liquidity problems by proving they still had access to the capital markets.

However it was not all that it was hyped up to be. The bonds were priced to yield 2.45 percentage points above yields on Treasury bonds. So what you say? Barry Ritholtz at THE BIG PICTURE pointed this out:

Just two months ago, a junk bond rated “B” was yielding that same 2.45 percentage points over Treasurys, a record low. The so-called spread on junk bonds has since jumped to 4.18 percentage points. Bear sports an “A+” credit rating, but appears to be paying a lot more than most “A” corporate bonds, which are currently yielding 1.25 percentage points more than Treasurys, according to a Merrill Lynch index.

The hefty rates Bear is paying on its new bonds illustrate “a willingness to secure liquidity at any price,” analysts from Banc of America Securities noted in a report. The large premium also implies that other companies that want to tap the investment-grade bond market may have to pay significantly higher rates, they added.

Anyway let's not badger the bear too much. Let's somebody else, how about my old firm - back in the news for all the wrong reasons. BNP Paribas has taken up the mantle of hedge fund disaster bank. From marketwatch.com

BNP suspends funds amid credit-market turmoil

LONDON (MarketWatch) -- BNP Paribas, one of the largest banks in France, said Thursday that it will stop valuing three of its funds and is suspending investor withdrawals after U.S. subprime-mortgage woes led to the "complete evaporation of liquidity," the latest sign of housing market troubles in the world's biggest economy rippling across the globe.

A spokesman said the total value of the three funds had fallen roughly 20% to just under 1.6 billion euros in less than two weeks. He added the funds had a total subprime exposure of around 700 million euros on July 27, though he didn't have any data on how much it had fallen since then.

This is the part I like best:

"The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating," the bank added in a brief statement.

What exactly is fairly? The mark to fantasy model that has been employed up till now? The real problem is not that there is suddenly a lack of liquidity, there has never been any liquidity in terms of cash for those who want out - at least not for those who want out at the same time. An illusion of liquidity has been masked in huge piles of debt and then dressed up as liquidity.

Michael Shedlock of MGETA has a great article explaining the current state of play.

Where the heck is the cash?

With that out of the way, where the heck is all the cash if so much of it is sitting on the sidelines?
For starters there is always "sideline cash" (well sort of but not exactly). The "sort of" is that for every stock buyer there is a seller. If there is a billion dollars on the sidelines waiting to buy stocks there will be still be a billion dollars on the sidelines after those stock purchases because for every buyer there is a seller. So the sideline cash theory is just circular logic. A better way to look at things is mutual fund cash levels. They have never been lower. And with massive hedge fund withdrawal requests there are more looking to get out than get in.

But is that really cash that's sitting on the sidelines in the first place? It looks like it but it's a mirage. (This is the "not really" side of the argument.) It is really sideline credit. And the opposite side of the credit ledger is debt. There is staggeringly little cash relative to credit. I talked about this recently in Fleckenstein (and others) State the Deflation Case.

The top is only beginning to wobble. When people tell me "there is so much money out there" I tell them that no, there is so much credit out there. This will be a muli-year process of debt reduction and deflation to correct what the Fed has wrought.

The above snip is thanks to Minyanville's Mr. Practical.

Here is a second snip from Fleckenstein (and others) State the Deflation Case. This one is from Trotsky.

[Credit vs debt is at the root of the misunderstandings of the inflation vs. deflation debates]. Because credit is used as a money substitute in the financial markets, it acts as an inflationary force in the asset markets (and this spills over into the real world as the imaginary wealth thus created leads to overconsumption and malinvestments), but it is all ephemeral - in the end, it is still credit, not money. As soon as money is needed in lieu of credit, such as has now happened in the CMO and CDO markets, it becomes clear that the money simply isn't there."

So there you have it. There is actually very little real cash out there relative to credit. The "sudden demand for cash" is in fact the world's biggest margin call to date. And in spite of saying they wouldn't fund a mispricing of risk the ECB is attempting to do just that. The Fed will too. But it won't work for the simple reason it can't work. Credit far exceeds both underlying asset values and real cash. Sideline cash is really sideline credit and in such cases problems occur when the pool of greater fools runs out and/or credit funding is cut off for those fools. Look at canceled IPOs for the score. Also look at M3 compared to base money supply to see just how out of whack things are. The implications are certainly not inflationary. All it takes to tip over the wobbling top is a change in attitude toward risk and a repricing of a significant portion of assets. Both are happening now.

The article also points out the contradictory nature of the ECB which flooded the markets with 95 billion euro when they have explicitly said in the past that they wouldn't do such a thing.

The ECB said today it provided the largest amount ever in a single so-called "fine-tuning" operation, exceeding the 69.3 billion euros given on Sept. 12, 2001, the day after the terror attacks on New York.

Click here for the full article: